Seven Short Selling Tips

Short selling is a way to bet that a certain stock will be lower in the future. Basically you sell a stock that you don't own in the expectation that it will decline and you can buy (cover) it a lower price in the future. It's just like buying low and selling high, except that you do it in reverse order.

At Cabot, we don't have any official short selling tips, in part because interest in the topic is far smaller than it is for traditional long investing, and in part because it's more difficult.

One, fear is a more intense emotion than greed, and thus big drops tend to happen quickly. That means your market timing when shorting must be very precise, which is difficult for even the best professionals.

Two, the mathematics of the proposition are less attractive. When you go long, the worst you can do is lose all your money; the best you can do is unlimited gains, 10-fold, 20-fold and more. But when you sell short, the best you can do is double your money (less commissions.) The worst you can do is unlimited; you can lose 10 or 20 times your money!

Another factor, immeasurable but important, is psychological. We prefer to hone our skills in going long, discovering great growth companies and buying their stocks at the right time. To contaminate that thinking by looking for the opposite would hurt our efforts in the main, most profitable avenue of investing, and we think it's not worth it.

However, if you're determined to sell short, I do have a little advice. Here are seven short selling tips:

– Target companies with declining sales and earnings.

– Target stocks of large companies that have declining public and institutional perception. That creates a large supply of selling pressure.  (Can you think of any automobile manufacturers or airline companies that qualify?)

– Only sell short when the market's intermediate-term trend is down.

– Never (never!) try to pick the top; only sell short stocks that are in confirmed downtrends.

– Pick your sell point carefully, trying to sell after the end of a normal rally upward, preferably to the declining 50-day moving average.

– Don't get greedy. When you have a decent profit after an extended period of downside action, take it.

– And finally, cut all losses short. If the stock continues to rally after you short, cut your loss at 10% to 15%.

The most dangerous way to sell short is to pick a hot little stock that's "way overvalued" and bet that it will come down.

Timothy Lutts can be found on Google Plus.

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